When it comes to measuring professional services profitability, many firms have a myopic focus on revenue generation and resource utilization with the hopes that profitability will be there in the end. While revenue growth and healthy utilization are essential, forgetting to manage your profit margins can have a dramatic impact on the business’s performance. The most successful professional services firms know this all too well.
In a recent infographic we broke down the extreme impact profitability can have on a professional services firm. We used the lens of what it takes to earn $10 million in profit and how the strategies and tools a firm uses can have a significant influence on profitability. In this post we’ll take a look at a few of the common myths that still surround measuring professional services profitability.
Calculating professional services profitability is a mix of art and science. If any of the these statements sound familiar, it may be time to take a look at how you structure and organize your work.
"Profitability is part of our hourly bill rates, so there is no point in measuring it"
While hourly bill rates should be set at a level that ensures profitability, they do not guarantee it. Using bill rates as a profit target ignores the other factors that go into delivering a project. Rework, schedule slippage, overtime, and scope issues all have an influence on profitability.
What to do instead
The most successful professional services firms will build a bottom up revenue forecast for each one of their projects. These forecasts will contain details about the type of resources needed, their bill rates, and their labor costs. This resource mix will provide a planned profit target for the project.
During the delivery process managers can keep tabs on the resource mix and its contribution to profitability. If the project drops below its profit target, they can take actions like using more experienced team members to avoid “write-downs."
"This project is fixed price, so we don’t need to track time against it"
This sentence is actually saying: “this is a fixed price project, so let’s see how much money we can lose.” Not tracking effort against projects, regardless of the professional services contract structure being used, is one of the biggest mistakes firms make. Making accurate estimates is hard, and if an estimate is off by just a little it will erode profit margins. Without tracking time throughout the project, you’ll have no idea if your margins are starting to slip.
What to do instead
Track every hour, against every project, always. Successful firms know this, and they drive a constant drumbeat of time compliance. Accuracy and timeliness when it comes to tracking effort pays dividends. It results in greater visibility into utilization and profitability, faster process improvement based on actual effort, and quicker invoicing. Add these factors together and your professional services firm has a wealth of information for identifying problem areas, creating better estimates, and getting paid faster.
"We won’t really know the profitability of this project until it’s done"
This myopic view is similar to the one above, and often associated with fixed price contracts. Reason being, calculating profitability on fixed price projects can get a bit complicated. The revenue amount is fixed but the cost is highly variable. But giving up on measuring profitability, just because it is complicated, will create problems for your professional services firm. Understanding how to measure profit margins during a project will influence how that project is managed, resulting in better performance.
In fact, most modern professional services automation solutions (often abbreviated as PSA, these are the core operational system for professional services firms) take care of the heavy lifting. These tools are able to calculate mid-project profitability on fixed price work out of the box. SPI Research’s recent Professional Services Maturity Benchmark Survey highlighted just how much influence PSA software can have on project margins. Compared to businesses that did not run their professional services firm on a PSA solution, those who did saw nearly 25% stronger project margins! That translates into some serious bottom line growth.
What to do instead
Successful professional services firms leverage purpose-built tools that do a good job modeling their business and organizing their work. These systems manage revenue on fixed price work based on effort to date and effort needed to complete the project. This revenue recognition approach unlocks mid-project profitability. It provides managers with a precise picture of project health, no matter where the project is in the delivery process.
Moreover, using a PSA solution will consolidate the soloed information that exists in stand-alone time entry, project management, scheduling, and budget tracking solutions. They also help to eliminate the series of loosely connected spreadsheets many professional services firms operate on. This delivers a single version of the truth and does a much better job of providing the right information, to the right people, at the right time.
"We are not billing the client for this, so we should put it on an internal admin project"
Another mistake when calculating professional services profitability is to treat non-billable time differently than you would billable time. If the work is related to a client or project, then it should have an influence on profitability. This will often show up in the sales process when the project hasn’t been won yet. Building out estimates, compiling proposals, and negotiating contracts all take time and should be factored into project profitability.
If you don’t, you profit margins will be overstated and you may not be bidding your jobs at a rate that will truly earn your target margin.
What to do Instead
Track sales time and other non-billable effort the same way you would any other project-based time. But segment it appropriately so that a long sales cycle doesn’t make the project manager look like she delivered a less profitable project.
The way you organize your work is crucial when it comes to tracking non-billable time. Successful firms will often deploy two strategies to account for this time. The first is a multi-project approach. Pre-sales efforts go against their own project. Then, if the business is won, a second project manages the delivery effort. These two projects would both roll up to the same contract, engagement, and client. This allows for profitability analysis at different levels. It also helps managers understand the impact of pre-sales effort for the project and a client as a whole.
The second approach focuses on capturing labor cost for things like defective work, relationship management, and general goodwill. To successfully capture this time, firms need the ability to track it within a project’s task structure. This will allow team members to associate non-chargeable time with the appropriate task, providing further visibility into where problems occur.
"Labor cost is too sensitive or complex to track in our project delivery system"
At the core of all of these common struggles that professional services firms have when it comes to calculating profitability is the assumption that the firms are, in some way, tracking their labor investment on each project. For your professional services firm, however, that may not be the truth. Many professional services firms, especially those who have not adopted a robust project delivery platform, shy away from loading labor costs into their project tracking. This is either because the tools they use do not have the capacity to track that information, or they are worried that the information will fall into the wrong hands.
These are valid concerns, but the visibility into mid-project profitability also carries tremendous value. With it, you can understand project health through a fourth dimension that is often overlooked by traditional project management methods—value of the project to the organization. Traditional project management methods balance budget, schedule, and quality as the indicators project success. Yes, these are crucial, and focusing on only one often comes at the detriment of the others, but ask any professional services executive what makes a successful project and they’ll probably tell you “a happy client and a healthy profit.”
What to do Instead
Leverage a robust project delivery platform, such as a PSA solution, to model labor rates and control access to sensitive information. The first step to this process is determining who in your organization should have access to this information, and the answer to that will be different for every firm. Some organizations will allow project managers visibility into margins directly, and others will reserve that information for delivery or program managers.
Regardless of your firm’s approach, a robust PSA tool will help with this effort. Most solutions on the market have tight permissions surrounding labor cost information. Some will go even further by allowing labor rates to be entered as a range for a specific type of employee and separating visibility into actual cost and margin percent into different permission structures.
These two approaches allow organizations to communicate general cost and profitability without identifying any one person’s specific salary or hourly pay. While this won’t provide exact profitability information, it will paint a picture that is close enough for managing a successful project.
Eliminating the Barriers to Measuring Professional Services Profitability
Measuring profitability in a professional services firm can be tricky. These are just five of the most common objections that firms face when trying to establish frameworks for profitability measurement. Regardless of how successful or sophisticated your professional services firm may be, one fact remains—real-time visibility into profitability drives stronger margins.
So if any of the excuses outlined in this post sound familiar to you, maybe it’s time to take a look at how your firm organizes their work, the systems and tools that support their delivery process, and the flow of information necessary to deliver successful projects. At the end of the day, what professional services firm wouldn't want more on time, under budget, high quality, and profitable projects?